Before I tell you why bonds belong in a retirement account, I’d better inform you that most advisors don’t agree.  The fact is, it’s the rare counselor who will recommend anything other than equities—stocks or mutual funds, with many advocating index funds.  So perhaps I’d better speak to that before giving my divergent opinion.

Irrespective of the basic soundness of the investment advisory profession itself, the overwhelming fixation of most practitioners is on common stocks, often consolidated in one or more mutual funds.  There are legitimate reasons why the common stock approach makes sense for the advisors, if not always for their clients.  The primary reason is that common stock in a public corporation now occupies an anointed status within both the investment and the legal communities.  Within most limits, an advisor is held blameless if recommendations on this investment vehicle prove less than astute.  And, as expected, with common stocks widely touted, natural client resistance is reduced.

Whatever else may be said about common stocks (and there is much), their general acceptability seems established in the realm of folklore.  There is an analogy which comes to mind of another American tradition: that the best food in the diners and cafes along the nation's highways is found where there are the greatest number of parked trucks.  It is rumored that someone once polled the thirty-five truck drivers eating lunch at one favorite truck stop along old Route 66 outside Albuquerque, New Mexico, to see why they preferred that cafe.  The results may seem contrary to expectations.  One driver owned a small interest in the cafe; a second dated the morning shift waitress; a third noted he always got sleepy at that point on his run; and the other thirty-two said: "Because I always see a lot of trucks parked here, and you know that means the food must be good."

As for the fixation on mutual funds, my discomfiture is with the evolution of an industry in which the placing of investors' money seems, at best, a secondary consideration.  The fact that a substantial and growing percentage of the nation's assets is now committed to funds fuels a part of the concern.  The rapid growth in the numbers and varieties of funds offered triggers more uneasiness.  But it is the synergistic effect, coupled with basic human nature, that could result in unpredictable problems for the economy and the nation.

Let me run the risk of asking rhetorical questions.  Who are the thousands of officers and directors of the newly forming funds?  How did the investors' interests advance when the average fund manager's annual compensation increased to over $1,000,000 in 1996?  What is the background and experience of the multitude of securities analysts employed?  Who will benefit from the growing trend in fund mergers, and in what fashion?  Is the investor really well served by a fund that merely places its monies in proportion to a specifically designed index or another that simply acquires shares of other funds?  And above all, who in God's name is watching the store?

What the future holds for the mutual fund industry is hard to say, but one thing is certain: The fortunes to be made, legally or otherwise, fuel an insidious attraction.  Is it becoming a self-propelled labyrinth, with few realistic controls, in the hands of the sort of corporate executives that are today attracting front-page coverage?  If so, the nation will surely experience a misfortune of momentous proportion.

This, then, brings us to today’s subject.  Though interest-bearing securities such as corporate bonds and treasury obligations are regarded as the investment for the rich and sedentary, my belief is that they belong in any growing estate, and the sooner, the better.  What occurs is a multiplying effect that, over time, is little short of phenomenal.  It is said that someone once asked Thomas Edison, in his later years, to identify mankind's greatest invention.  His response: "compound interest."  Whether the tale is true is of little importance.  What really matters are the actual results of a series of investments, at a predetermined rate of interest, over a prolonged period.  An excellent application of this principle would be in a tax-deferred retirement program such as an Individual Retirement Account (IRA).  Consider the following scenarios of a twenty-five-year-old woman, embarked on her retirement program, in which she places into her account $3,000 on the first day of each year until age sixty-five.  What might she expect?

If the money goes into the proverbial mattress, earning no interest, her stash, forty years and forty payments later, is $120,000 [$3,000 X 40 = $120,000].  As investments go, this qualifies as less than bountiful, though I’ve known of worse.

Luckily our someday-retiree is a bit shrewder than to let her money sit unproductively.  Instead she chooses, using the IRA self-directing feature, to purchase corporate bonds, with excess funds to remain as a money market portion of the account.  As the bonds normally pay interest every six months, the additional cash earns at market rates until enough collects for additional bond purchases.  On this basis, the compounding effect is no less frequent than semiannually.  Presuming she has chosen bonds of sufficient quality and maturity so to suffer no market losses, the important question is what interest rate must she seek for an adequate result?  At an annual return of 7½ percent over the forty-year term¾certainly not unreasonable¾the value of her fund will grow to $752,900.

The secret ingredient in the mix is the compounding effect, which is as close to magic as you will possibly ever get.  What occurs, simply, is that when paid, the interest earns interest, which in turn earns interest, which in turn . . . I think you get the picture.  This multiplying effect resembles a geometric progression¾a sequence in which the ratio of a term to its predecessor is always the same.  Perhaps it passed over your head when first exposed to the principle in high school math, but as a get-rich-steadily device it is a winner.  This intense rate dependency makes the tax-exempt or tax-deferred account ideal for compound interest investments, and for this reason corporate bonds are a splendid retirement fund holding.  This is also why municipal bonds, which carry lower rates and are largely tax exempt anyway, do not belong in a tax-deferred account.  And while on the subject, it makes less than good sense to place deeply discounted low-interest or zero coupon bonds into a retirement account, as full advantage of the multiplier effect is not realized.

The last element you must consider is how to go about selecting suitable bonds.  Though not a matter of intense complexity, a number of factors are involved, and it must be done correctly.  This is a subject not universally understood, even by many in the securities industry.  For a reasonably thorough step-by-step description of how to analyze and acquire corporate bonds, you are invited to read Chapter 6 of my book, Nobody’s Fool: A Skeptic’s Guide to Prosperity, available through Amazon and Barnes & Noble, or ordered by mail from my website at www.onthemoneytrail.com. 

Let me add a final word on this subject.  Don’t expect much encouragement from securities professionals for investment in interest bearing vehicles.  With the exception of bond funds, that generally serve the investor poorly, corporate bond purchases normally provide the broker far less in commissions than do stocks or stock funds.  Keep that in mind as you pursue this program.